Separating Productivity and Quality Effects from Relative Prices

Abstract

Based on a general equilibrium model, we derive a relative price function which can be decomposed into productivity and quality effects. We then develop a method for inferring relative quality changes and apply that to US services versus US goods using NIPA data from 1946-2005. First, relative quality was decreasing after 1946 and has been increasing since the 1970s. Second, relative productivity and quality are negatively correlated, suggesting an endogenous link between the two. Third, productivity changes alone cannot fully explain the evolution of the services-goods relative price. This suggests that ignoring quality variations when explaining relative prices or exchange rates can lead to incorrect conclusions.